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 Tuesday 13 June 2017

FOMC look-ahead - PM Bulletin



The US Federal Reserve is currently engaged a two-day rate-setting meeting which concludes tomorrow evening. This is an important meeting, not just because the Fed expected to raise rates by 25 basis points for the third time since December, but also because the FOMC will publish its latest quarterly Summary of Economic Projections. This is where all seventeen members of the FOMC (not just those who have a vote on the rate itself) give their personal forecasts for GDP growth, inflation, unemployment and the headline federal funds interest rate for the next three years and beyond. This includes the famous (or infamous) “dot-plot” which is a pictorial representation for their fed funds forecasts.

According to the CME’s FedWatch Tool the probability of a 25 basis point rate hike tomorrow is around 99.6%. This is as good as a complete certainty coming just hours ahead of the announcement. Even a weak CPI inflation report tomorrow afternoon is unlikely to throw the Fed off balance at this late stage. Meanwhile, the FedWatch tool ascribes a 23% likelihood of a further 25 basis point rate hike by September, and this rises to 39% by the end of the year. In this respect, the market is a touch less hawkish than the FOMC - at least when looking at the central bankers’ March “dot-plot”. This had a majority of FOMC members projecting a fed funds rate of 1.4% or above by year-end.

But there’s also the question of reducing the Fed’s $4.5 trillion balance sheet which most commentators believe will begin before the end of this year. The expectation is that some further details may be forthcoming tomorrow, as no doubt Fed Chair Janet Yellen will be asked about it during her press conference.  But some point out that balance sheet reduction this year could be a problem as the Fed is tightening monetary policy in order to normalise interest rates against a backdrop of weakening economic data. And while the consensus expectation is that US economic growth as measured by GDP is set to continue to pick up albeit at a subdued pace, the real problem is that there’s been a downturn in inflation. In common with a number of central banks the Fed has a 2% inflation target. While inflation as measured by the Fed’s preferred PCE measure is close to this target, it has not only failed to hit it but has been trending down over the past few months. Year-on-year core PCE is down 0.2% from the March meeting when we had the last Summary of Economic Projections. This is a problem for the Federal Reserve as it would like to be overshooting its target as it raises rates, not undershooting it.

Yet unemployment, the other half of the Fed’s dual mandate is down 0.4% over the same period. At just 4.3% it now stands at its lowest level since the first quarter of 2001. A number of Federal Reserve regional presidents have said that this pretty well represents full employment in the US. If that’s what they think, then this should offset any concerns they may have about a downturn in inflation. And if so, then we should expect the Fed to be fairly hawkish tomorrow. If so, then we may get a pick-up in the dollar. However, it’s worth considering that there may be greater slack in employment than is being picked up by the headline data. After all, there are a very large number of discouraged would-be employees who have given up looking for work. For this reason they aren’t counted as being unemployed. Consequently, if these people return to the jobs market then there’s little chance of serious wage growth adding to inflation anytime soon. If that’s the case then raising rates and reducing the balance sheet further this year could lead the US economy to stall.


Posted by David Morrison

Category: PM Bulletin

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